Institutional investors use a variety of tools to gain commodities exposure, including private markets, but the trend towards active management is unstoppable, a forum heard.

Diego Parrilla, founder and chief investment officer of Nareco Advisors, was speaking during a panel discussion on institutional routes into commodities at AsianInvestor’s and FinanceAsia‘s commodities investment summit in Hong Kong last week.

Parrilla cited examples of hedge fund managers playing commodities through a construction company in Mongolia, via the Aussie dollar or through bonds issued by Brazilian oil firm Petrobas.

While he described himself as a fan of precious metals exchange-traded funds (ETFs) and acknowledged the need for commodity benchmarking, nevertheless he argued that active management was the best tool to help investors understand the risks.

“Commodities are too complex, too broad and too diverse for anyone in this room,” he stated. “The trend towards active management is unstoppable and I think the pockets in which this is happening will continue to expand, more so because of the lack of options.”

Parrilla pointed to difficulties for investors when instruments such as ETFs are not physically backed by an underlying commodity but by futures contracts.

“When investors are accessing commodity ETFs they are not only exposed to the price risk of the commodity, there is another variable called the roll that they can’t control and can’t understand, which has been extremely negative,” he added.

He noted one way to mitigate negative carry in a contango market was to buy longer-term contracts, but then investors miss out on the potentially explosive returns of a front-end future. “To the extent that the carry is a major component of returns is something to be mindful of,” he cautioned.

Parrilla admitted he was biased against commodity equities because of inherent risks including taxation and nationalisation and geopolitics, and pointed to rolled returns as a negative for commodity indices. “Ultimately you want to get as close to the physical as you can,” he stressed.

Paul Colwell, investment consultant in the portfolio advisory team at Towers Watson, noted one of the reasons that institutional investors had been attracted to commodity indices in the past had been the insurance premium they were getting paid.

“But over the last decade that has changed and they are paying forward now, so that has changed the rules of the game,” he added. “Many of our clients are very unhappy that they are not getting the underlying commodity exposure they thought they were getting.”

As a result institutional investors were looking at alternative routes into commodities and better implementation. Pension funds, for example, were beginning to think about accessing private markets and looking at natural resources as a specific target – although still not in large numbers.

Colwell emphasised that a lot of due diligence is required with private equity-type structures focused on natural resources.

“You are buying into a management team and you need to understand their experience and how they can add value,” he said.

“The other thing that needs to be considered is many of these private market players are not looking for price exposure, but for operational improvement in the underlying asset and they are looking to develop the production base of that asset.”

Asked how institutional investors might pick and monitor active managers in this arena, Colwell highlighted the importance of transparency over the positions taken in a portfolio.

He said some institutional investors preferred to target illiquid investments: “Some of the larger sovereign wealth funds and government pension funds are actively looking at timberland and agriland. Other access points may be mature oil rigs. They are looking for long duration-type exposure where they can get a premium for the liquidity.”

Parrilla, too, highlighted the need for investors to understand fully the risks involved. While Mongolia was identified during the discussion as the new kid on the block, with its abundant resources and potential, the panellists agreed it was also facing tremendous challenges.

But one area Parrilla was unreservedly bullish on was natural gas, which he predicted would change the world. “It is clearly the future of transportation and hopefully that will break the oil chain,” he claimed.

“This is a path for cheap energy, but how do you play that story? It is a bit of an art and a science to decide which [commodity] to get, and when.”

Looking at the macro environment and expansion of the global monetary base, Parrilla suggested it would not take a genius to spot that an inflation problem was around the corner.

He suggested the most likely channel of adjustment would be commodity inflation, particularly energy, food and precious metals. While base metals would be a good hedge, he said, the minus was that they are cyclical and more abundant.